Corporate Risk: At This Point There Is More Downside Than Upside

As we’ve stated in recent market notes and quarterly conference calls, we have grown somewhat cautious on corporate credit. It is best to anticipate a turn in the market and position ahead of widening spreads, but as we all know, the signs are not always obvious when it comes to calling an inflection point.

One caution sign we see this year is corporate spreads modestly widening from historically very tight levels. Some of this widening we attribute to technical factors. There is less buying support from foreign buyers as hedging costs rise in tandem with LIBOR spreads. There is also some selling pressure while corporate treasurers unload short-term bank bonds as part of their cash repatriation program.

But some of this widening, we believe, its attributable to investors acknowledging that corporate earnings are peaking, balance sheets are cyclically fully leveraged, and current tight spreads may not fully compensate for risks at this point in the cycle. Recently we have seen BBB’s start to widen vs A’s, and we believe this could be one of the early signs that all spreads may continue to drift wider as this long-lasting credit cycle starts to fade.

What makes calling the inflation point an art rather than a science is that not all signs are pointing in the same direction. For example, high yield spreads are, in some cases, holding in better than investment grade spreads. Perhaps in this yield starved environment greed still overcomes fear, or perhaps high yield default rates are still very low.

Heeding the above caution signs, we have peeled back some corporate risk in portfolios. At this point in the cycle there is more downside than upside, so it makes sense to act on these early signs and anticipate the turn.